How Does Apollo Investment Corporation Make Money?

Apollo Investment Corporation (NASDAQ: AINV) makes money by lending to midsize companies ($50 million to $2 billion in revenue) and by buying/selling their debt and equity.

It should be noted that AINV both buys debt and originates it; in other words, it's not just a lender or just an investor -- it can do both. This makes AINV quite a diversified BDC.

So, what does AINV do? Let's look a little deeper.

Debt portfolio Corporate loans can vary quite a lot in terms of structure and risk, and AINV's loan book is no exception. As of March 31, 2014, 56% of AINV's portfolio consisted of secured loans, meaning that they are backed by collateral, while 27% were unsecured, meaning they aren't backed by collateral.

This is quite a change from a few years ago. In March 2012, AINV's lending was the opposite: the company held only 30% of its portfolio in secured loans and 60% in subordinated debt.

So, what happened?

AINV is repositioning its portfolio to reduce risk. From the most recent 10K: "We believe a higher exposure to secured debt better positions the portfolio to withstand market and economic volatility." Considering that BDCs employ leverage to fund their investments, risk carries a lot more weight -- borrowing in order to lend means that your returns, whether positive or negative, are magnified.

In other words, AINV realizes that the temperate market conditions we're currently enjoying aren't going to last forever. Preparation for higher interest rates in the future is also driving the AINV portfolio toward floating rate loans, which now make up 42% of the portfolio, compared to 33% in in 2012.

The cost to reducing risk is that yield will decline, and indeed we've seen that with AINV. It's weighted-average yield has fallen by almost 1% since last year. A desire to keep yields higher could be part of the reason AINV hasn't moved completely away from subordinated debt and into the secured loan space, and it also explains why the company invests in equity and structured products.

Equity investmentsAINV has 11% of its portfolio in equity investments, which can include common stock, preferred stock, and warrants. These investments generate income through dividends and capital appreciation. Preferred stock tends to provide more dividend yield than common stock, but in both cases the dividends are optional, meaning that each company's management can choose not to issue a dividend in a given period.

Equity holdings boost the yield of the AINV portfolio, as these dividends tend to be higher, but they also introduce more risk. After all, aside from dividends, the stock price of a company tends to be more volatile than the value of its debt. If AINV is counting on equity dividends and/or capital appreciation to help boost its returns, it's obviously at the cost of higher risk.

Structured productsAside from its other holdings, AINV invests in debt and equity structured products like collateralized loan obligations and credit-linked notes. These are generally pooled assets which are split into segments (tranches) based on their risk, and they make payouts to investors based on the interest payments or dividends of the underlying investments.

Obviously, this type of investment carries additional risks. The structure doesn't allow for insight into what's happening in the underlying portfolio, and, as mentioned above, using leverage means that returns -- both positive and negative -- are magnified. Structured products also carry a degree of "moral hazard" risk because the entity originating the loans and packaging the product isn't necessarily going to experience the consequences of its lending decisions.

Structured products currently make up 6% of the AINV portfolio.

Overall AINV's portfolio is diversified across several types of assets that each carry their own risks and rewards. Whether a diversified strategy works depends in part on expertise and the drivers of the diversification. In other words, can the company effectively make investment decisions across such a broad array of categories? Does management pursue diversification because of competitive advantage or as a way of utilizing capital and driving returns? These are questions we'll explore in another report.

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